Inventory journal entries record every purchase, sale, and adjustment that moves stock through the books, and the entries look different depending on whether the business uses a perpetual or periodic inventory system. Under a perpetual system, the Inventory account and Cost of Goods Sold update in real time with each transaction. Under a periodic system, those figures are calculated only at the end of the accounting period using a physical count. Getting the entries right is what makes the balance sheet show the correct unsold stock and the income statement show the correct gross profit.
Perpetual and Periodic Systems Behave Differently
The perpetual system tracks inventory continuously. Every purchase adds to the Inventory asset account, and every sale triggers two entries: one to record the revenue and one to move the item’s cost out of Inventory and into Cost of Goods Sold. Managers can check stock levels and turnover at any point without waiting for a physical count.
The periodic system takes a simpler route. It uses temporary holding accounts (Purchases, Freight-In, Purchase Returns and Allowances, Purchase Discounts) throughout the year, and the Inventory account itself sits untouched until year-end. At that point someone physically counts everything on the shelves, and COGS is backed into using a formula: Beginning Inventory + Net Purchases − Ending Inventory.
One consequence to keep in mind before recording anything: under a periodic system, inventory shrinkage from theft, breakage, or recording errors gets buried inside COGS. Missing units simply show up as fewer items in the count, and the formula treats them as if they were sold. A perpetual system flags the gap between the ledger and the count, making losses visible.
Recording Inventory Purchases
Assume a company buys $10,000 of merchandise on credit with payment terms of 2/10, Net 30 (a 2% discount if paid within 10 days, full amount due in 30).
Under the perpetual system, the entry increases the asset directly:
- Debit: Inventory — $10,000
- Credit: Accounts Payable — $10,000
Under the periodic system, the entry goes to a temporary account:
- Debit: Purchases — $10,000
- Credit: Accounts Payable — $10,000
The Inventory account stays unchanged until the year-end adjustment.
Freight-In
Shipping costs to bring inventory to your location get capitalized as part of inventory cost. If the company pays a $500 freight bill, the perpetual entry adds it to the asset:
- Debit: Inventory — $500
- Credit: Cash (or Accounts Payable) — $500
The periodic entry routes it through a temporary account:
- Debit: Freight-In — $500
- Credit: Cash (or Accounts Payable) — $500
The Freight-In balance folds into the COGS calculation at year-end.
Purchase Returns and Allowances
If $500 of merchandise turns out to be defective and is sent back to the supplier, the perpetual system reduces Inventory immediately:
- Debit: Accounts Payable — $500
- Credit: Inventory — $500
The periodic system uses a contra-purchases account:
- Debit: Accounts Payable — $500
- Credit: Purchase Returns and Allowances — $500
That contra account reduces Net Purchases when COGS is calculated at year-end.
Purchase Discounts
Assume the company pays the $10,000 invoice within the 10-day discount window and earns the 2% discount ($200 savings). Most companies use the gross method, which records the purchase at full price and recognizes the discount only when payment falls inside the window.
Under the perpetual system:
- Debit: Accounts Payable — $10,000
- Credit: Cash — $9,800
- Credit: Inventory — $200
Crediting Inventory keeps the asset at what the company actually paid. Under the periodic system:
- Debit: Accounts Payable — $10,000
- Credit: Cash — $9,800
- Credit: Purchase Discounts — $200
Recording Sales and Cost of Goods Sold
When inventory is sold, the revenue entry looks the same regardless of system. Assume the company sells goods that originally cost $6,000 for a selling price of $15,000 on credit:
- Debit: Accounts Receivable — $15,000
- Credit: Sales Revenue — $15,000
The cost side is where the two systems part ways.
The COGS Entry
Under the perpetual system, a second entry is recorded at the same time as the sale, moving the cost of the sold goods out of the asset account and into expense:1Lumen Learning. Sales Under a Perpetual System – Financial Accounting
- Debit: Cost of Goods Sold — $6,000
- Credit: Inventory — $6,000
Under the periodic system, no entry is recorded for cost at the point of sale. The Inventory account sits untouched, and COGS is not recorded until year-end closing.
Sales Returns
When a customer returns merchandise, the sale needs to be partially or fully reversed. Suppose a customer returns $1,500 of goods that originally cost $600 to acquire.
The revenue reversal is identical under both systems:
- Debit: Sales Returns and Allowances — $1,500
- Credit: Accounts Receivable — $1,500
Only the perpetual system records a second entry that puts the goods back into inventory and reverses the expense:2LibreTexts. Seller Entries Under Perpetual Inventory Method
- Debit: Inventory — $600
- Credit: Cost of Goods Sold — $600
Under the periodic system, no second entry is needed. The returned goods show up in the year-end physical count, and the COGS formula self-corrects because ending inventory is higher than it would have been otherwise.
How FIFO, LIFO, and Weighted Average Change the Numbers
The dollar amounts that go into those COGS entries depend on which cost flow assumption the company uses. When identical items are purchased at different prices over time, the business has to decide which cost gets attached to the units sold and which cost stays with the units still on the shelf. The journal entry structure is the same. The dollar amounts change.
FIFO (First In, First Out)
FIFO assumes the oldest inventory is sold first. In a period of rising prices, FIFO assigns the lower, earlier costs to COGS and leaves the newer, higher costs in ending inventory. The result is lower COGS, higher gross profit, and a higher inventory balance. It tends to match what physically happens in most businesses, especially those with perishable goods.
LIFO (Last In, First Out)
LIFO assumes the newest inventory is sold first. During inflation, LIFO assigns the higher, more recent costs to COGS and leaves the older, cheaper costs in ending inventory. This produces higher COGS and lower taxable income. LIFO is not permitted under International Financial Reporting Standards, and in the U.S. any company that uses LIFO for tax purposes must also use it in the financial statements reported to shareholders, creditors, and partners.3Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories
Weighted Average Cost
Weighted average divides the total cost of all inventory available for sale by the total number of units, producing a single blended cost per unit that applies to both COGS and ending inventory. Under a periodic system, the average is calculated once at the end of the period. Under a perpetual system, a new average is recalculated every time additional inventory is received.
A quick illustration. If a company bought 100 units at $10 in January and another 100 units at $12 in February, then sold 120 units, FIFO would assign the first 100 at $10 and the next 20 at $12 for COGS of $1,240. LIFO would assign the first 100 at $12 and the next 20 at $10 for COGS of $1,400. Weighted average would use a blended cost of $11 per unit for COGS of $1,320. Same physical transaction, three different profit figures.
Year-End Closing Entries Under the Periodic System
The periodic system does its heavy lifting at year-end. Throughout the year, the temporary accounts (Purchases, Freight-In, Purchase Returns and Allowances, Purchase Discounts) accumulate data, but the Inventory account on the balance sheet still reflects last year’s ending balance. Closing entries replace that old number and calculate COGS in one shot.
Assume a beginning inventory of $20,000, purchases of $10,000, freight-in of $500, purchase returns of $500, purchase discounts of $200, and an ending inventory count of $18,000. First, clear out the temporary accounts and the old inventory balance:
- Debit: Income Summary (or COGS) — $29,800
- Credit: Inventory (beginning balance) — $20,000
- Credit: Purchases — $10,000
- Credit: Freight-In — $500
Then bring in the contra accounts and the new ending inventory:
- Debit: Inventory (ending balance per count) — $18,000
- Debit: Purchase Returns and Allowances — $500
- Debit: Purchase Discounts — $200
- Credit: Income Summary (or COGS) — $18,700
Temporary accounts now have zero balances, the Inventory account shows the current physical count, and COGS flows to the income statement. Any errors in the physical count ripple through every line on the income statement, and there is no running ledger to check against.
Adjusting Entries for Shrinkage, Write-Downs, and Obsolescence
Even under a perpetual system, the ledger balance does not always match what is physically on the shelves, and sometimes inventory still on hand has lost value. Both situations call for adjusting entries.
Inventory Shrinkage
After a physical count, the perpetual system may reveal that recorded inventory exceeds actual inventory. If the ledger shows $50,000 but the count reveals $49,000, the $1,000 gap (typically from theft, damage, or counting errors) must be expensed:4Corporate Finance Institute. Inventory Shrinkage – Definition, Causes, and Impact
- Debit: Cost of Goods Sold (or Inventory Shrinkage Expense) — $1,000
- Credit: Inventory — $1,000
Some companies use a dedicated Inventory Shrinkage Expense account rather than lumping the loss into COGS, which makes it easier to track shrinkage trends. Either approach is acceptable under GAAP. Under the periodic system, shrinkage never gets its own entry; missing units are absorbed automatically into the COGS formula.
Lower of Cost or Net Realizable Value
GAAP requires inventory to be reported at the lower of cost or net realizable value (NRV), the estimated selling price minus reasonably predictable costs to complete and sell the goods. The rule prevents companies from carrying inventory at a cost that exceeds what they will actually recover.5Financial Accounting Standards Board. ASU 2015-11 – Inventory (Topic 330) Simplifying the Measurement of Inventory
This standard applies to inventory measured using FIFO or weighted average. Companies using LIFO or the retail inventory method still apply the older “lower of cost or market” test, which compares replacement cost against a ceiling (NRV) and a floor (NRV minus a normal profit margin).5Financial Accounting Standards Board. ASU 2015-11 – Inventory (Topic 330) Simplifying the Measurement of Inventory
The write-down entry is the same under both inventory systems:
- Debit: Loss on Inventory Write-Down — amount of decline
- Credit: Inventory (or Allowance for Inventory Write-Down) — same amount
Crediting Inventory directly reduces the asset’s carrying value. Using a contra-asset Allowance account preserves the original cost on the books while still reporting the lower net value on the balance sheet. For tax purposes, the IRS permits taxpayers to use the lower of cost or market method under IRC 471, with mechanics that differ slightly from the GAAP treatment.6Internal Revenue Service. Lower of Cost or Market
Obsolescence Reserves
Inventory that has not lost market value yet but is becoming slow-moving or outdated calls for an obsolescence reserve rather than an immediate write-down. Estimate probable losses each period rather than waiting until the goods are worthless.
To establish the reserve:
- Debit: Obsolete Inventory Expense — estimated loss amount
- Credit: Allowance for Obsolete Inventory — same amount
The Allowance sits as a contra-asset, reducing net inventory on the balance sheet while leaving the original cost in the Inventory account. When the goods are finally scrapped, the allowance is reversed against the Inventory account. If the company sells obsolete goods for salvage value, the difference between the allowance and the proceeds flows through COGS or a separate loss account.
Consignment Inventory Stays With the Consignor
Consignment arrangements trip up bookkeepers because the goods are physically located at one business but legally owned by another. The consignor (the owner who ships goods to a retailer) keeps the inventory on their balance sheet. The consignee (the retailer displaying the goods) never records the consigned stock as an asset.
When the consignor ships goods to the consignee, the entry reclassifies the inventory rather than removing it:
- Debit: Inventory on Consignment — cost of goods shipped
- Credit: Inventory — same amount
No sale has occurred. When the consignee sells the goods to an end customer, the consignor records the revenue, recognizes COGS, and books the consignee’s commission as an expense. The consignee records only a liability for the proceeds owed to the consignor and recognizes their commission as income. A consignee who mistakenly records consigned goods as their own asset will overstate inventory on the balance sheet.
Tax Reporting Ties Back to the Journal Entries
Inventory journal entries feed directly into federal tax reporting. Corporations filing Form 1120 (and its variants for S corporations, cooperatives, and foreign entities) and partnerships filing Form 1065 must complete and attach Form 1125-A, Cost of Goods Sold, whenever they claim a COGS deduction.7Internal Revenue Service. About Form 1125-A, Cost of Goods Sold The form walks through the same components the entries produce: beginning inventory, purchases, labor, other costs, and ending inventory.
The cost flow assumption has direct tax consequences. LIFO, which generally produces higher COGS and lower taxable income during inflationary periods, carries the conformity requirement of IRC 472(c): a company that elects LIFO on the tax return must also use LIFO in every financial statement provided to shareholders, lenders, and partners.3Office of the Law Revision Counsel. 26 USC 472 – Last-in, First-out Inventories Issuing financial statements under FIFO while claiming LIFO on the tax return can cause a company to forfeit the LIFO election. The journal entries are the audit trail that shows the books and the return agree.